Some Notable Events in 2007
New Century: 4/2/07 (REIT with market cap of $1.75 billion on 1/1/07, delisted 3/13, filed for bankruptcy 4/2)
S&P/Moody’s significant downgrades beginning in June 2007 Bear Stearns suspends redemptions: 6/7/07
Bear Stearns liquidates funds: 7/31/07
BNP Paribas funds: 8/9/07
The ABX-HE (or just “ABX”), is an index of credit default swaps (CDS) written on subprime mortgage securitizations. The price of the ABX index is essentially a measure of perceived value of subprime securities with various ratings; the return (or spread) on the ABX is essentially a risk premium for subprime.
The index was created by the firm Markit, and first released in January 2006 covering the 20 largest subprime securitizations that closed in the last six months of 2005. These indices were denoted as ABX-HE 2006-1. Subsequent releases were denoted 2006-2, 2007- 1, and 2007-2 before subprime activity became too small for index construction.
The launch of ABX in 2006 was a notable event, as it allowed everyone to see, speculate, and hedge – for the first time – market expectations about subprime.
How Could We Be So Wrong?
“… given the fundamental factors in place that should support the demand for housing, we believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system.” – Chairman Bernanke in a speech on May 17, 2007
The bad news in subprime was well-known by the time of Chairman Bernanke’s speech. Indeed, the news events in the spring of 2007 seem uncorrelated with the movements in the ABX.
Instead, the problem became the uncertainty about the location of subprime risk. Which securitized bonds were exposed to subprime? Which financial institutions would need to support their investment vehicles?
The financial system is not equipped to analyze “safe” investments. The resources for deep analysis of information are not there.
Consider what you would do if you had uninsured deposits at a bank, and you became nervous about the bank’s solvency. Is it rational to analyze the bank’s balance sheet, or to just take your money out?
The London Interbank Offered Rate (LIBOR) is a measure of the interest rates that banks charge each other for unsecured dollar funding over various time periods (overnight, one-month, threemonth etc.)
The Overnight Index Swap (OIS) is a fixed-floating interest-rate swap for various time periods. Because the amounts owed daily are small and counterparties must continuously post collateral for expected payments, the fixed leg of this swap is considered to be a good proxy for risk-free interest rates.
The LIBOR-OIS spread is thus a good measure for the riskiness of banks’ unsecured borrowing. Historically, this spread was very small (around ten basis points).
Asset-Backed Commercial Paper
Asset-backed commercial paper (ABCP) is primarily a method of maturity transformation – funding a pool of long-term assets with short-term liabilities.
ABCP is designed to meet specific needs of investors (often money-market mutual funds), and includes credit enhancement and liquidity support to achieve this goal.
ABCP vs. Securitization
ABCP may appear similar to securitization, but there are many differences:
- Investments can be revolving and fluctuate in size
- Conduits may invest in various asset types
- Typically engage in maturity transformation, with backup liquidity support
- No scheduled amortization of assets and liabilities
ABCP programs grew rapidly in the 1990s, and then again in the crucial 2003-2007 period.
As of 2007, ABCP programs took many forms, and were not dominated by any particular type of sponsor.
Covitz, Liang and Suarez define an ABCP “run” as a week when the program does not issue new CP despite having at least 10% of outstanding CP mature.
Runs became endemic in August 2007, and once a program experienced a run it was unlikely to ever leave that state. By December 2007 more than 40% of programs were in a run state.
The problems in subprime were clear to all market participants in early 2007.
These problems were not expected to infect the whole financial system, but uncertainty about the location of risks led to a spread of anxiety beginning in the middle of 2007.
The anxiety is driven by a financial system ill-equipped to analyze risks in seemingly “safe” assets. This sets the stage for a good oldfashioned bank run, but now taking place in the shadow banking markets.
Special thanks to Timothy F. Geithner (Lecturer in Management, Yale SOM, Former U.S. Secretary of the Treasury, Yale School of Management) and Andrew Metrick (Michael H. Jordan Professor of Finance and Management, Yale School of Management)